Investing is all about numbers. Portfolio returns are critical, details about how they were achieved secondary. But numbers sometimes confuse more than they inform.
Understanding that reality is essential to make sense of current 3- and 5-year returns for stock mutual funds.
Current gaps between those common performance benchmarks are so huge that they don't seem credible. For example, most index funds tracking the Standard & Poor's 500 have delivered 3-year annualized returns around 28 percent a year _ phenomenal, if those numbers could be sustained. Yet over five years, returns averaged less than 2 percent, roughly keeping pace with inflation.
The index fund results are on par with the 26 percentage-point difference between 3- and 5-year returns for diversified stock funds, the type that make up the bulk of most investor portfolios. The average is based on data from fund tracker Morningstar, through Wednesday.
The reason the numbers are so disparate? Funds are now wiping their 3-year records clean of the stock meltdown that ended March 9, 2009. Five-year records look comparatively awful because they include the market's 57 percent plunge from October 2007 to March 2009.
The gaps are even larger at many funds using high-risk strategies unsuitable for most investors. Among more than 5,000 diversified stock funds, the biggest gap is 92 percentage points, belonging to Direxion Monthly Small Cap Bull 2x (DXRLX). Its annualized 3-year return is a dazzling 75 percent per year, while it has lost an average 17 percent over five years. The fund tracks an index of volatile small-company stocks, delivering double the average monthly gains _ or losses _ of the Russell 2000.
And there's no shortage of mainstream, large funds whose volatile returns have resulted in 3- vs. 5-year gaps far wider than the 26 percentage point average. For example, Legg Mason Capital Management Opportunity (LMOPX) has a 48-point gap, while Vanguard Capital Value (VCVLX) has a 42-point spread.
The bottom line for investors is that it's crucial to put current 3- and 5-year returns in context. They're a quirk of the calendar, and an illustration of the market's bust-to-boom cycle the past few years.
The huge gaps are mostly noise for long-term investors who stay on track with a well-designed plan. But over a volatile stretch like the past five years, the damage can be long-lasting for investors who got scared and sold investments as the market was hitting bottom, missing the recovery.
Here are a few tips for keeping current 3- and 5-year fund returns in proper context:
_Seek steady returns: Funds with unusually volatile returns frequently outperform peers over brief periods, and in some cases for several years. But such volatility can often bring out the worst in investors prone to making short-term moves based on emotion. Fear bred by market declines often causes investors to miss eventual recoveries, and greed during rallies can lead to buying into a market that's near its peak. Consider a low-volatility approach.
Tom Roseen, a Lipper Inc. fund analyst, puts it this way: "Find a fund with a good steady manager at the helm, who can hit doubles and triples, even if they don't hit many home runs." Several funds that aim to deliver smooth returns currently have small 3- vs. 5-year gaps, with strong overall returns. One example: Forester Value (FVALX), with a 3-year average return of nearly 17 percent, and a 5-year average of 3 percent. Credit manager Tom Forester's defensive style, emphasizing stable dividend-paying stocks. This fund also frequently maintains a large cash position in its portfolio, providing a cushion when stocks are declining.
_Be mindful of the difference a year can make: Many funds with the best records of recent years stand out because they limited their losses in 2008, when stocks plunged 38 percent. Outperformance during market declines can be crucial, because losses have a bigger impact on long-term results than comparable gains. If stocks lose 50 percent in value, it's important to remember that you'll need a 100 percent gain _ not 50 percent _ to get back to where you started. It's a reality that led to standout performance from Reynolds Blue Chip Growth (RBCGX). Sensing trouble in the housing market, manager Frederick "Fritz" Reynolds began selling stocks and holding on to cash as subprime mortgage troubles rippled into the stock market. His fund lost just 5 percent in 2008, among the smallest losses that year for large-cap growth funds. As the market turned in March 2009, Reynolds was shifting back into stocks. Reynolds' 5-year record, with an average annualized gain of 14 percent, is best among hundreds of funds in its category. Reynolds achieved that distinction with just 9 percentage points separating its 3- and 5-year returns.
_Invest based on performance over long periods: Quirks like the current 3- vs. 5-year gaps crop up from time to time after the market has gone through a volatile stretch. Volatility is likely here to stay, so don't overemphasize those 3- and 5-year numbers when assessing a fund's record. Give more weight to a fund's 10-year record, or even a longer period if data are available.
_Diversify: For most investors, diversification _ spreading holdings among several types of investments, across a broad swath of the stock and bond markets _ pays off. It means an investor will rarely outperform the market by a significant margin. But diversification can limit losses in downturns, and usually results in stronger long-term returns. To stay truly diversified, rebalance holdings periodically to restore an appropriate balance of stocks to bonds.
Questions? E-mail investorinsight(at)ap.org